The market’s most crowded trades could be causing dangerous bubbles

The market may be blowing up some bubbles through excessive crowding.

Bubbles, simply put, are sins of excess driven by too many people reaching for too few goods.

The tech bubble saw investors clamoring for a piece of internet gold, which drove valuation to a popping point. The housing bubble saw similar events occur in the real estate market.

It is not unreasonable then to think that investors would be crowd-averse. Too much money rushing into too few assets has a history of ending in disaster.

Except by the looks of it, there may be some serious crowding happening in markets. The questions then become: are these crowded bubbles? And if so, when do they pop?

There’s nowhere else to go

Before we get into the question of where does it go, finding out how we got here is necessary.

The main culprit is the new reach for yield. With low returns in many asset classes and yields on many bonds in developed markets heading negative, there has been a need to push into risky, higher yielding assets to make up the difference.

“You haven’t heard the term ‘crowding’ out in quite a while, but quite frankly that’s what [quantitative easing] is,” said Mike Siegel, global head of Goldman Sachs Asset Management Insurance Investing division.

“It’s the Federal Reserve, the Bank of Japan, the ECB going into the market buying high quality government bonds and taking them out of the market and crowding everybody else out and forcing them into other securities.”

While Siegel is speaking specifically about insurance investors here, it applies to the whole market, and as investors get crowded out of some assets they have to find somewhere else to go. With fewer options and lower returns, you end up with the bubbly looking trades.

‘No doubt in my mind’

This push for yield has manifested in a number of places in both the stock and fixed income markets.

“There is no doubt in my mind that there is crowding,” John Bailer of BNY Mellon’s The Boston Company told Business Insider. “The perception is that interest rates are going to stay low for a long time so people are trying to pile in wherever they can.”

Bailer, the portfolio manager of the The Boston Company’s Income Stock Fund, said that dividend paying stocks are especially crowded, as not only equity investors but many funds treating these stocks as bond substitutes.

“People are hiding out in stocks that they think are safe, growing assets and that is looking like it’s under pressure,” said Bailer.

This causes dislocations in the market as certain companies end up with much higher valuations than would be reasonable. Bailer mentioned both dividend paying defensive stocks and high growth names that have exploded higher recently (think FANGs) as areas he sees as particularly pressured.

Kathy Jones, chief strategist for fixed income at Charles Schwab, told Business Insider that much the same thing is happening in the bond market.

“Get used to it,” said Jones. “There’s crowding as people are coming to the market trying to find somewhere that will get them a good yield and that ends up in a lot of people being in fewer assets.”

Additionally, as we’ve noted before, UBS has quantified bubbles both in the stock and bond markets that are ripe to pop.

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It seems certain assets may be overflowing with investors.

How it all ends

There is some good news, however. While bubbles have a propensity to pop, there is the option of slowly releasing the pressure through bad returns.

“Markets tend not to reward crowded stocks,” said Bailer. “So eventually investors are going to have to find somewhere else to get returns.”

Additionally, UBS’ quant team found that some pressure was being released from the most popular bubble trades as conditions changed.

The only issue there is that the underlying dynamics that are leading people into crowded trades aren’t changing. Central banks aren’t raising rates anytime soon, so yields will most likely stay low, and investors will have to find the few trades where they can get high returns. This leads a lot of investors to a few high return names, and you end up back in the bubble.

Plus, bubbles tend to pop when most people least expect it, so there’s also that. Basically, it may pay to find a trade with a little more elbow room.

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